Capital Formation from the Investor’s Perspective

Editor’s Note: Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s remarks at the AICPA Conference on Current SEC and PCAOB Developments; the full speech, including footnotes, is available here. The views expressed in this post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

I would like to talk about capital formation and the critical role that accountants play in that process. I want to particularly focus on capital formation from the investor’s perspective. Too often, the investor perspective is lost in the discussion over capital formation. The companies, lawyers, and investment bankers that often dominate this discussion often see regulation only as an obstacle to be overcome. They focus the discussion on how to raise money quicker and more cheaply — but seem to forget that the money raised comes from the pockets of hard-working Americans. The capital raising process should not make investors more vulnerable, and attempts to raise money quicker and more cheaply should not come at the investor’s expense. I want to put the focus on investors and examine how protecting investors facilitates capital formation by enhancing confidence, promoting integrity, and fostering transparency.

A Perfect Storm

Just five weeks ago, we witnessed the devastation of a “perfect storm.” Images from coastal New Jersey and other areas affected by Superstorm Sandy make clear that, for many of our neighbors, recovery will be a long and difficult process.

Five years ago, we were hit with another type of “perfect storm” as the housing bubble burst and global credit markets began to freeze. The perfect storm of the financial crisis also led to a long, slow, and uneven recovery that left all too many Americans underwater.

One persistent after-effect of the financial crisis has been a loss of confidence in the securities markets among individual investors. A recent survey finds that only 17 percent of Americans trust the stock market. Average daily trades in U.S. stocks are about half their 2008 peak. From 2006 through 2011, U.S. domestic equity funds experienced a total outflow of half a trillion dollars. Some of this shift may be a natural result of the aging population of baby boomers, but there may also be a decline in the willingness of even younger investors to invest in the stock market. Looking back over a longer timeframe, the number of U.S. IPOs fell sharply after the tech bubble burst in 2000 and never truly recovered, particularly in the case of smaller companies with sales of less than $50 million per year.

To the list of factors contributing to the loss of confidence is the recurring news of household names being sued by the SEC for fraudulent behavior, dramatic breakdowns in corporate governance, or other misconduct. It is understandable that investors feel uneasy. It’s hard for them to know whether the capital markets are trustworthy.

Obviously, we need to turn this trend around. It is clear that if you want people to invest in the capital markets, you have to foster trust in the capital markets — and for that to happen, the capital markets must be trustworthy.

I know that the AICPA shares this perspective. As an organization responsible for setting ethical and professional standards for accountants, the AICPA is the public representative of a rigorous and noble profession. As financial statement preparers and auditors, accountants have a special responsibility to help make sure the capital markets are trustworthy. You are important “gatekeepers.” Your professional training and experience prepare you for this role, and whether you work in industry or in public accounting, your clients and colleagues look to you for guidance. Investors count on you as well, to make sure they get the information they need to make good investment decisions. The work of the accounting profession is critically important to investors and absolutely central to capital formation.

Understanding True Capital Formation

Before discussing the role that accountants play in maintaining investor confidence and in fostering fair and efficient capital markets, let’s first make sure we’re on the same page when we talk about capital formation. Capital formation is much more than just capital raising. By itself, selling a bond or a share of stock doesn’t add a thing to the real economy, no matter how quickly or cheaply you do it. True capital formation requires that the capital raised be invested in productive assets — like a factory, store, or new technology — or otherwise used to make a business more productive. The more productive those assets are, the greater the capital formation from the investment — and, importantly, the more jobs created.

Unfortunately, the reverse is true as well: When investor funds are diverted away from productive uses, capital is destroyed. Scam artists and promoters can be very effective at raising money, but accounting frauds, Ponzi schemes, and “casino capitalism” are the black holes of capital formation. They attract investment dollars and make them disappear. We see this again and again in cases brought by the SEC and other regulators: All too often, by the time the fraudster is caught, investor funds have been dissipated and the defendant is judgment-proof. The result is that investors are left holding the proverbial bag — their money lost and their dreams shattered.

My experiences as an SEC Commissioner make it clear to me that rules to promote full and fair disclosure, reliable financial information, and accountability for market participants are absolutely necessary. When properly enforced, such rules help to deter fraud, protect investors and enable true capital formation. This happens in a variety of ways:

Investor Protection is Necessary for True Capital Formation

First and foremost, protecting investors promotes true capital formation by providing investors with the confidence they need to invest. Investors must have confidence in the integrity of the capital markets to invest their savings in stocks, bonds, mutual funds and other securities. They must have confidence that the markets are fair and that the rules are effectively enforced. And they must have confidence that the information available is meaningful, accurate, and complete.

Members of the accounting profession can help to promote this confidence, through your roles in a regulatory system that requires, among other things, accurate disclosure of financial and other material information, independent audit committees with financial expertise, effective and efficient internal controls, and diligent, independent and professionally skeptical auditors. These safeguards work together to ensure that public company financial statements are accurate, informative and reliable.

Second, true capital formation requires that investment decisions be based on reliable and useful information, so that investors can better price risk and determine value. This in turn increases the likelihood that capital will be invested productively. The goal of such transparency is not to eliminate risk — all investments carry a degree of risk. The essential thing is that investors are fully informed of the risks, so that they can decide where, when and how to put their money to work.

Third, widespread access to reliable financial information lowers the cost of capital by reducing the risk premiums demanded by investors. When a market has sufficient information, and confidence in that information, investors will tend to bid-up the price of quality investments, lowering the cost of capital for such issuers. However, if information is lacking, unreliable, or difficult to compare, investors will tend to “overpay” for low-quality securities and “underpay” for high-quality ones. This interferes with the efficient allocation of capital, and negatively impacts capital formation. When investors have no confidence that the market knows how to price a security, then no transactions in that security will take place. This is a situation to be avoided, because when market information becomes unreliable, it is the honest and lower-risk businesses that, in effect, subsidize the dishonest or higher-risk businesses.

In other words, true capital formation is best facilitated when investors and other capital providers have the information they need to make informed decisions.

However, experience tells us that it is not enough to simply require disclosure. Effective regulation also requires oversight, enforcement, and important procedural safeguards. For example, for publicly-traded companies, these built-in safeguards include, among many others, the independent audit, a system of internal control, and an audit committee comprised of independent directors. These safeguards, in particular, rely on the participation of accountants with, as established by the AICPA Code of Professional Conduct, a professional duty to “serve the public interest, honor the public trust, and demonstrate commitment to professionalism.” When members of the profession act with integrity, objectivity and due care — and when auditors in public practice are independent in both fact and appearance — that is when they can truly fulfill their role as gatekeepers, helping to protect the integrity of our capital markets.

Clearly, this is in the best interests of investors, and our economy. There is no substitute for an environment where investors can rely on the integrity of published financial information.

U.S. Investors Must Be Able to Rely on the Integrity of Foreign Audits

This is not just important in the United States. It is also important to recognize that capital formation is a global process. Many large U.S. companies have operations all over the world, and businesses of all sizes from other countries come to the United States to access our capital markets. Accordingly, foreign operations of U.S. issuers are often reviewed by foreign auditors, including the local affiliates of the major global accounting networks, as well as independent firms.

U.S. investors rely on the work product of these foreign auditors when making investment decisions, often without knowing the role the foreign accounting firm played in the audit. This lack of transparency, made worse by news reports of audit failures in China and other countries, can create uncertainty in the capital markets. Last year, with a goal toward improving transparency, the Public Company Accounting Oversight Board (PCAOB) proposed amendments that, among other things, would require disclosure in the audit report of other accounting firms that took part in the audit, including foreign firms. This transparency regarding the audit participants would be a step forward for investors.

In addition, I remain seriously concerned about the lack of effective oversight regarding foreign auditors that issue audit reports or participate in the audits of U.S. issuers. Like U.S. firms that audit public companies, these foreign audit firms must register with the PCAOB. As such, they are subject to periodic inspections, including review of work papers for selected audits.

Unfortunately however, although many foreign-based firms currently cooperate with the inspection regime, the PCAOB has been prevented from inspecting the audit work of accounting firms in certain European countries, China, and — to the extent their audit clients have operations in China — Hong Kong. Chinese regulators have resisted direct inspections by U.S. regulators for years.

The PCAOB’s inability to inspect the Chinese operations of registered accounting firms is a particular problem, given the number of claims in recent years regarding potential fraud or other irregularities at China-based companies traded on U.S. markets. I have spoken before about my concerns regarding the many claims related to smaller companies that entered the U.S. markets through reverse merger transactions, further reducing transparency.

It has been widely reported that the PCAOB has been working to resolve this situation, and I commend the PCAOB for its efforts. In fact, just last month, for the first time, representatives of the PCAOB were able to observe audit inspections by Chinese regulators. While this is by no means a substitute for a PCAOB inspection, I am hopeful it is a first step to achieving the ultimate goal of a full inspection.

A related issue has been the difficulty in obtaining access to accounting work papers and other documentation. It’s no secret that the SEC has been investigating accounting irregularities at dozens of China-based companies that are publicly traded in the United States. However, those investigations have been hampered by the lack of access to relevant documents, many of which are located overseas.

It is obvious that SEC enforcement staff often need access to audit work papers to investigate possible financial fraud claims. In fact, Section 106 of the Sarbanes-Oxley Act, as amended, requires foreign public accounting firms to provide audit work papers concerning U.S. issuers to the SEC upon request. Unfortunately, when we made these requests of audit firms in China, it was an act of futility. As a result, in May of this year, the Commission filed an enforcement action against the Shanghai member firm of a Big Four global accounting network for its refusal to provide the Commission with audit work papers. This particular action related to a China-based company under investigation for potential accounting fraud against U.S. investors.

Commission staff had sought to obtain such documents for more than two years before bringing that action. The Shanghai-based auditor refused to provide the documents, citing Chinese law as the reason for its refusal.

Regardless of Chinese law, however, the fact remains that foreign auditors in China and elsewhere have voluntarily registered with the PCAOB and have chosen to perform audit work for U.S.-listed issuers, knowing full well that U.S. investors would be relying on their audit reports and other work product. If these firms are unable or unwilling to comply with U.S. law, the question to ask is whether the companies they audit should be allowed to trade in the U.S. securities markets?

This is a question that must be answered with the needs of investors in mind — both to protect investors and to promote capital formation. Uncertainty regarding audited financial statements hurts investor confidence in the securities of all issuers whose operations are based in places opaque to regulatory oversight.

This has been an open issue for some time, and it is past time that it be resolved.

The Role of the PCAOB

In this regard, I would like to recognize the important role of our regulator in this space, the Public Company Accounting Oversight Board. As this group knows well, the PCAOB was established in response to the Enron, WorldCom and other accounting scandals of the “dot-com bubble” era. These scandals were widely seen as a failure of the gatekeepers: Not just accountants and auditors, but boards of directors, securities analysts, credit rating agencies, and sophisticated institutional money managers as well — all of whom seemingly closed their eyes to complex financial frauds designed to maximize the company’s stock price by any means available, regardless of the underlying economic reality.

Under the Sarbanes-Oxley Act of 2002, the PCAOB is charged with overseeing the audits of public companies to protect the interests of investors and to further the public interest in the preparation of informative, accurate, and independent audit reports.

As you likely know, this summer marked the 10th anniversary of the Sarbanes-Oxley Act. Over this period, the PCAOB has conducted nine annual inspection cycles, and the largest accounting firms — that is, those that issue audit reports for 100 or more public companies — are audited annually, so there is a wealth of information about audit quality that can be analyzed.

Unfortunately, the available data raise serious issues about the quality of many audits. For the 2010 inspection cycle — the most recent year for which complete results are available — the PCAOB issued inspection reports for all eight accounting firms in the “annual inspections” category. In the aggregate, these firms are responsible for auditing the financial statements of the great bulk, by market capitalization, of public issuers. In each case, the PCAOB identified multiple audits with deficiencies, and multiple deficiencies that rose to the level of audit failures. Moreover, the evidence suggests that these results were not an aberration. Many common deficiencies cited in these recent inspection reports were also identified as frequent weaknesses in the PCAOB’s report on audit risk areas affected by the economic crisis, which focused on the 2007, 2008 and 2009 audit cycles. Moreover, early results from the 2011 cycle also indicate an unacceptable level of audit deficiencies.

The audit failures revealed by the PCAOB damage investor confidence, discourage investment, and impede the efficient allocation of capital required for true capital formation.

I know you will agree with me that this is not acceptable. In light of these concerns, the PCAOB is currently considering a wide range of potential approaches for improving audit quality. I appreciate the work that the PCAOB does to protect investors and promote financial transparency and I look forward to its recommendations. I encourage the AICPA and its members to be active participants in this dialogue, and I know many already are.

The Importance of Internal Controls

As we consider the critical role that accountants play in promoting transparency, protecting investors and facilitating true capital formation, it is also useful to consider the importance of effective internal control over financial reporting (often referred to as ICFR).

It has long been recognized that effective systems of internal controls are fundamental to reliable financial reporting. For more than 70 years, the Commission’s rules for certifying financial statements have required independent auditors to consider the adequacy of the issuer’s internal control system in determining the scope of their audits. As far back as 1940, the Commission found that an accountant’s determination regarding the effectiveness of the client’s internal controls was a “cornerstone of any examination of financial statements.” And for a quarter of a century, companies subject to SEC reporting have been required to maintain internal control systems sufficient to provide reasonable assurance that their financial reporting is reliable.

Given the importance of an issuer’s internal controls to effective auditing, investors should know about any material deficiencies or weaknesses in those controls. And given the importance that accurate financial statements have to investors, it is regrettable that Section 404(b), and its requirement for auditor attestation of internal controls, have so often been a target for criticism. The argument critics make against auditor attestation is that the costs outweigh the benefits, particularly for small and medium-sized companies. However, there is ample evidence to rebut that argument:

First, evidence shows that independent attestation of internal controls promotes good financial reporting. Last year, as required by the Dodd-Frank Act, the SEC’s Office of Chief Accountant completed a study and recommendations on Section 404(b) for issuers with a public float between seventy-five million and two hundred fifty million dollars. The study concluded that “financial reporting is more reliable when the auditor is involved with ICFR assessments” and that “investors generally view the auditor’s attestation on ICFR as beneficial.”

In particular, the Study found evidence that auditor testing of internal controls has generally resulted in the disclosure of control deficiencies that were not previously disclosed by management. Auditor testing also appears to have a positive effect on the quality of financial reporting generally. The Study stated that issuers that only filed Section 404(a) reports — that is, management certification, without 404(b) auditor attestation — were significantly more likely to restate their financial statements than issuers that complied with both Section 404(a) and Section 404(b). The benefits of auditor attestation are confirmed by other commenters as well, including the Council of Institutional Investors, the Center for Audit Quality, and the AICPA.

Second, it has been generally reported that the cost of complying with Section 404(b) has moderated substantially in the years since first implemented.

However, despite evidence of Section 404(b) benefits to investors and the public interest, and despite evidence that the costs of this requirement are manageable and declining, there have been repeated efforts to limit the auditor attestation requirement. In 2010, the Dodd-Frank Act permanently exempted all smaller reporting companies from the requirements of Section 404(b). This year, the JOBS Act expanded the list by exempting so-called “emerging growth companies” from Section 404(b). This is a very broad exemption, as the definition of “emerging growth company” includes businesses with up to $1 billion in annual gross revenue, for up to five years after their initial public offering. I am concerned that the rollback of Section 404(b) will be harmful for both investors and the capital markets. Uncertainty regarding the reliability of financial reporting is likely to damage investor confidence. This could actually reduce demand for the securities of these companies, raising their cost of capital and harming, rather than helping, the market for IPOs.

In fact, there is data to back this up: Researchers have found that companies that voluntarily comply with Section 404(b) experience a lower cost of capital, including a decline in the cost of equity and debt capital in the first year of compliance. In other words, auditor attestation of internal controls enhances financial transparency, protects investors and promotes true capital formation.

Given this evidence, I strongly support retaining the benefits of Section 404(b) for all companies currently subject to it. The SEC and PCAOB should also continue to monitor the financial reporting and internal controls of those issuers that have already been exempted from Section 404(b), and we should not hesitate to call for the reinstatement of that obligation if necessary to promote capital formation and protect investors.


As gatekeepers, the AICPA and its members have a meaningful opportunity to protect investors, promote true capital formation, and uphold the integrity of the capital markets. The auditing profession has a proud history of working to improve audit quality for the benefit of investors and the public interest. Your commitment to providing accurate, meaningful, and reliable accounting, auditing and financial reporting is one of the reasons that the American economy is the envy of the world. In an increasingly global society, I believe that the work of the AICPA will have a positive impact not only in the United States but around the world. I know that you recognize your responsibility to investors and other financial statement users — and how essential your role is to the proper functioning of our capital markets.

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